SEC filings and annual reports: Separating the wheat

Financial filings and Annual reports:
Separating the wheat from the chaff
Aswath Damodaran
Aswath Damodaran
Data versus Information
In the interests of providing more information to investors, the SEC
and the accounting standards boards (GAAP, IFRS) have required
companies to reveal more and more about themselves.
That is good news, but it is also bad news. Financial disclosures from
firms have become “data dumps”, stretching to hundreds of pages and
several GB of downloads.
The key to using these financial disclosures in valuation and investing
has become separating the “stuff that matters” from the ‘stuff that is
Aswath Damodaran
The key to making the distinction between information &
Be focused: Reading financial statements cover to cover, looking for
“interesting” and “important” stuff almost never works. Instead, start
with focus, by defining the items that you want information on, at
least in broad terms, and then classifying what you find along those
Tie the information to your valuation model/metrics: Broadly
speaking, you can value a company in one of three ways:
Intrinsic or DCF valuation, where the value of a company is estimated by forecasting out
expected cash flows and discounting them.
Relative valuation, where you are using a multiple and comparable firms, to make a judgment
on value.
Contingent claim valuation, where you value a business as an option.
The information that you will get out of the financials will vary, depending on the
approach you use.
Aswath Damodaran
The drivers of value
Determinants of Value
Growth from new investments
Growth created by making new
investments; function of amount and
quality of investments
Current Cashflows
These are the cash flows from
existing investment,s, net of any
reinvestment needed to sustain
future growth. They can be
computed before debt cashflo ws
(to the firm) or after debt
cashflows (to equity investors).
Efficiency Growth
Growth generated by using
existing assets better
Expected Growth during high growth period
Terminal Value of firm (equity)
Stable growth firm,
with no or very limited
excess returns
Length of the high growth period
Since value creating growth requires excess returns,
this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages
Cost of financing (debt or capital) to apply to
discounting cashflows
Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing
Aswath Damodaran
The key valuation questions that you are trying to answer…
Key questions
Key inputs
Cash flows from
1. How much capital is invested in existing
2. How much did the firm earn on these assets?
1. Current revenues
2. Current earnings
3. Current capital invested
(Debt + Equity – Cash)
Future growth
1. How much growth from new investments?
2. How much growth from improved efficiency?
1. Revenue growth
2. Operating margin
Quality of
1. How much new capital will the firm have to
invest to deliver that growth?
1. Reinvestment
2. Return on invested
Operating Risk
1. What businesses does the firm operate in?
2. What countries does the firm operate in?
1. Relative risk (Beta)
2. Equity Risk Premium
3. Cost of capital
Financial Risk
1. How much debt does the firm have?
2. Are there any other contractual commitments?
1. Debt ratio
2. Cost of debt
Other assets/
1. Are there any non-operating assets?
2. Are there other claims on the equity?
1. Non-operating assets
2. Minority interests
3. Options outstanding
Aswath Damodaran
A template for reading a “financial” disclosure
Timing &
General: Period covered by the financials, Reporting currency
Business mix
General: Business segment breakdown (revenues), Geographic
breakdown (revenues), Specific risks (not generic)
Base year
inputs for
Income statement: Revenues, Earnings, Interest exp, Tax rate
Balance sheet: Book equity, debt outstanding, Cash & Working
capital (WC), Cross holdings (minority & majority)
Statement of cash flows: Change in WC, Capital Expenditures,
Depreciation, Debt issued (repaid)
Follow through Footnotes to financials: Operating lease, rental & other
commitments, Employee options, Timing of debt due, Under
funded obligations (pension & health care)
Share count: Number of shares outstanding, Restricted stock
units (RSUs), Acquisitions paid for with stock
General: Differences in voting rights across share classes,
special rights or privileges given to insiders etc.
Aswath Damodaran
Valuing Procter & Gamble: September 2012
The timing issue in financial statements
If you are valuing a company for a transaction (investment, acquisition
etc.), you should use the most updated information that you can find
on the company. While market numbers (interest rates, stock prices)
get updated constantly, accounting numbers get updated at prespecified intervals (usually) once every quarter.
To value P&G in September 2012, I started with the most recent 10K.
That filing, which was made with the SEC in August 2012, reflects
P&G’s financial year, which ends June 30, 2012. (See page 3 of the
10K). Since it is the most recent filing, it will be used in the valuation.
If the year-end in the last 10K had been December 31, 2011, I would
have obtained the last 10Q and calculated trailing 12 month numbers
for flow numbers (income statement & statement of cash flows) and
the balance sheet from the last 10Q for stock numbers (balance sheet).
Aswath Damodaran
The pre-read: Browsing the 10K
Aswath Damodaran
P&G: The key numbers…
Aswath Damodaran
Some parting advice (suggestions)…
Skip the pablum: Financial filings increasingly use legal boilerplate to
protect companies against lawsuits. Thus, much of the risk discussion
(P&G: 6-13) either states the obvious (“change in consumer
demand”) or says nothing of value ( “successfully manage
organizational change”)
Don’t sweat the small stuff: Significant sections of the financial filing
will be dedicated to issues that are immaterial to your valuation or too
“small” to make a difference. (See P&G Venezuela 34-35)
Cross check across financial statements: To make sure that you are
not missing items or to catch inconsistencies, cross check your
information. For instance, is the net capital expenditure in your
statement of cash flows close to the change in fixed assets on the
balance sheet? How about change in non-cash working capital?
Fill in the gaps: When you are missing information, make your best
judgments based on either the company’s past financial statements,
industry norms or common sense.
Aswath Damodaran